Abstract

The speed of leverage adjustment is a central issue in capital structure research, yet the role of economic freedom in explaining this speed has received limited attention in the domestic literature. This study examines the effects of economic freedom and its components on firms’ leverage adjustment speed using data from 127 firms (2,813 firm-year observations) listed on the Tehran Stock Exchange during 2002–2024. The System Generalized Method of Moments (System GMM) is employed, controlling for year and industry effects. The results show that economic freedom significantly increases leverage adjustment speed. Except for government size, all components - including legal system and property rights, sound money, international trade freedom, and credit, labor, and business regulation - have positive and significant effects. Robustness tests confirm these findings. Overall, greater economic freedom facilitates adjustment toward target leverage by reducing institutional frictions and adjustment costs, supporting trade-off theory.

Keywords: Economic Freedom, Fraser Index, Heritage Index, Leverage Adjustment Speed, Trade-off Theory.

1. Introduction

The speed of leverage adjustment is a central concept in the capital structure literature. According to the dynamic trade-off theory, firms seek to maintain an optimal leverage ratio that balances the benefits and costs of debt financing. However, adjustment costs prevent firms from instantaneously reaching their target leverage, resulting in a gradual adjustment process. The speed at which firms move toward their target leverage reflects the efficiency of this process. In recent years, researchers have increasingly emphasized the role of institutional environments in shaping corporate financial decisions. Economic freedom, as a broad measure of institutional quality, reflects the extent to which economic activities are supported by secure property rights, sound monetary policies, open markets, and efficient regulations. Despite its potential importance, limited evidence exists on how economic freedom affects leverage adjustment, particularly in emerging economies. Therefore, this study investigates the impact of economic freedom and its components on the speed of leverage adjustment among firms listed on the Tehran Stock Exchange.

2. Literature Review

The dynamic trade-off theory suggests that firms continuously adjust their capital structures toward target leverage levels. Factors that reduce adjustment costs are expected to increase adjustment speed. Economic freedom can influence this process by improving legal protections, reducing regulatory barriers, enhancing monetary stability, and facilitating access to financial resources. Prior studies have highlighted the importance of institutional conditions in corporate financing decisions. Research by Ameer (2013), Fan et al. (2012), and Aflatooni et al. (2022) suggests that institutional quality and economic environments significantly affect firms’ financing behavior. However, evidence regarding the specific role of economic freedom in leverage adjustment remains limited. Accordingly, this study examines the overall effect of economic freedom and the effects of its five components: government size, legal system and property rights, access to sound money, freedom to trade internationally, and regulation of credit, labor, and business. Based on the theoretical arguments and prior evidence, the following hypotheses are developed:

H1: Economic freedom positively affects the speed of leverage adjustment.

H2: Government size has a significant effect on the speed of leverage adjustment.

H3: Improvements in the legal system and property rights increase the speed of leverage adjustment.

H4: Greater access to sound money increases the speed of leverage adjustment.

H5: Greater freedom to trade internationally increases the speed of leverage adjustment.

H6: Better regulation of credit, labor, and business increases the speed of leverage adjustment.

3. Methodology

The study uses a sample of 127 firms listed on the Tehran Stock Exchange during 2002-2024, resulting in 2,813 firm-year observations. Firm-level data were obtained from financial statements and the Rahavard Novin database, while economic freedom data were collected from the Fraser Institute. The speed of leverage adjustment was estimated using a dynamic partial adjustment model. To address endogeneity concerns associated with dynamic panel models, the System Generalized Method of Moments (System GMM) estimator was employed. Year and industry effects were controlled for in all estimations. Book leverage was used as the primary measure of leverage. The models also included several control variables, including industry leverage, firm size, growth opportunities, profitability, asset tangibility, free cash flow, and capital expenditures. Robustness analyses were conducted using market leverage and the Heritage Foundation’s Economic Freedom Index.

4. Results

The findings indicate that firms gradually adjust their leverage toward target levels, supporting the dynamic trade-off theory. The results also show that economic freedom positively affects leverage adjustment speed, suggesting that firms operating in more economically free environments move more rapidly toward their target leverage. The analysis of individual components reveals that legal system and property rights, access to sound money, freedom to trade internationally, and regulation of credit, labor, and business all enhance adjustment speed, whereas government size has no significant effect. Robustness tests further confirm these findings. Similar results are obtained when market leverage and the Heritage Economic Freedom Index are used, indicating that the conclusions are robust to alternative measures of leverage and economic freedom.

5. Discussion

The findings support the view that institutional quality plays an important role in corporate financing decisions. From the perspective of the dynamic trade-off theory, economic freedom reduces institutional frictions and adjustment costs, enabling firms to move more efficiently toward their target capital structures. Economic freedom contributes to this process through stronger property rights, more effective legal systems, greater monetary stability, improved market access, and more efficient regulatory frameworks. These conditions facilitate financing activities and reduce the costs associated with capital structure adjustments. The results are consistent with prior studies emphasizing the role of institutional environments in corporate financial behavior, including Ameer (2013), Fan et al. (2012), and Aflatooni et al. (2022). The insignificant effect of government size suggests that the quality of institutions and market efficiency are more important than the scale of government involvement in explaining leverage adjustment dynamics.

6. Conclusion

This study examined the relationship between economic freedom and the speed of adjustment in an emerging market setting. The results indicate that economic freedom enhances firms’ ability to move toward target leverage. Among its components, legal system and property rights, sound money, freedom to trade internationally, and regulatory quality positively affect adjustment speed, whereas government size does not. The findings highlight the importance of institutional reforms aimed at strengthening property rights, promoting monetary stability, and reducing regulatory barriers. Such reforms can improve financing efficiency and facilitate capital structure adjustments. Future research may investigate the effects of economic shocks, such as the COVID-19 pandemic and economic sanctions, on leverage adjustment, as well as the roles of corporate governance, financial constraints, and economic uncertainty in shaping capital structure dynamics.